Strength in the financial system

The Australian financial system has characteristics that give rise to particular risks. The financial system is complex and highly interconnected with the rest of the world. Australia is a capital-importing nation with a significant component of domestic investment funded by foreign savings channelled through the banking system. The use of foreign investment, which the Inquiry expects to continue, has been advantageous for Australia, enabling higher investment and growth than would otherwise have been possible. Yet it also brings risks, such as vulnerability to a loss of foreign investor confidence, which may lead to increased costs and a sharp contraction in funds available for investment.

As the banking sector is at the core of the Australian financial system, its stability is of paramount importance. The sector is responsible for the majority of intermediation between savers and investors, and is highly interconnected with the rest of the financial system. In addition, the banking sector is concentrated, with the four major banks being the largest players in virtually all respects. This concentration, combined with the predominance of similar business models focused on housing lending, exacerbates the risk that a problem at one institution could cause issues for the sector and financial system as a whole. To prevent further concentration, the longstanding ‘Four Pillars’ policy, which precludes mergers between the four major banks, should be preserved as outlined in the Interim Report.

The importance of the banking sector means that it must be unquestionably strong to meet the needs of Australia. A number of aspects are critical to this strength, including an institution’s capital levels, liquidity, asset quality, business model and governance, and Australia’s sovereign credit rating. Australian authorised deposit-taking institutions (ADIs) are generally well placed in these respects, with strengthened capital and liquidity requirements, low loan losses, a business model focused on domestic and commercial banking, sound governance and a AAA-rated Government.

Of these, capital levels are particularly important, as they provide a safety buffer to absorb losses no matter what their source. In the Inquiry’s view, although Australian ADIs are generally well capitalised, further strengthening would assist in ensuring capital levels are, and are seen to be, unquestionably strong. Liquidity is also very important and must be readily available. Given the considerable strengthening of regulatory liquidity requirements underway — the effects of which have yet to be seen — the Inquiry has not made recommendations in this area.

Active supervision by APRA — a vital component that must remain strong. It is particularly useful for assessing the qualitative aspects of an institution’s strength, including through the Australian Prudential Regulation Authority’s (APRA) use of its Probability and Impact Rating System (PAIRS) risk assessment model.3

Systems for dealing with financial institution distress — where the strength of an institution proves to be insufficient, a robust framework for effectively resolving the failed institution is critical to minimise harm to the economy.

A robust stability framework provides a stable foundation for the financial system. Currently, financial system stability in Australia is underpinned by the continued strong financial performance of the banking system.4 Further, many of the reforms made to the Australian banking sector following the GFC have now settled. Strengthening necessary areas of the financial system at a measured pace now, rather than later, will cost less than actions to reinforce the system at a time when it is weak or where change must occur quickly. Reforms during good times also dampen pro-cyclicality in the financial system.

Determining the appropriate strength of stability settings is necessarily a matter of judgement. The Inquiry’s test has been one of public interest: the interests of individuals, businesses, the economy, taxpayers and Government. The Inquiry believes that, on the basis of public interest, the benefits of the recommended measures outweigh the associated costs. The GFC demonstrated that risks are real and the cost of complacency is very high.